Lecture 2

The Balance of Payments

Lecturer: Dao Mai Huong
LECTURE OUTLINE

 BOP definition and examples

 BOP components
 The
interaction between BOP and key
macroeconomic variables
The Balance of Payments

 The measurement of all international economic

transactions between the residents of a country and
foreign residents is called the balance of payments (BOP)
 Important for government policymakers and MNEs as it is a
measurement of a nation’s competitiveness or health
(domestic and/or foreign)
Fundamentals of BOP Accounting
 There are three main elements of the actual process of
measuring international economic activity:
 Identifyingwhat is and is not an international
economic transaction
 Understanding how the flow of goods, services, assets,
and money create debits (outflows) and credits
(inflows) to the overall BOP
 Understanding the book-keeping procedures for BOP
accounting
 A BOP statement is a statement of cash flows over an
interval of time.
The Accounts of the BOP
 The BOP is composed of:
 Current Account
 Capital and Financial Account
 Official
Reserves Account: tracks government
currency transactions
 NetErrors and Omissions (a.k.a Statistical
Discrepancies) Account: produced to preserve the
balance of the BOP
Current Account

1. Goods trade: Net exports/imports of goods (balance of

trade)
2. Service trade: Net exports/imports of services
3. (Factor) income: Net income (investment income from
direct and portfolio investment plus employee
compensation)
4.Current transfer: Net transfers (sums sent home by
migrants and permanent workers abroad, gifts, grants, and
pensions)
Examples
Examples
 Current account
Transactions Types Inflow/
outflow

J.C. Penney purchases stereos produced in Indonesia

that it will sell in its U.S. retail stores.

The Mexican government pays a U.S. consulting firm

for consulting services provided by the firm

A U.S. investor receives a dividend payment from a

French firm in which she purchased stock.

The United States provides aid to Costa Rica in

response to a flood in Costa Rica.
Exhibit 4.2 The United States Current Account,
2002-2010 (billions of U.S. dollars)
U.S. Trade Balances on Goods and Services, 1985-2016
(billions of US dollars)
The Capital and Financial Account

 TheCapital Account and financial

accounts: measures all international
economic transactions of financial assets.
The Capital Account
 Consist of:
 Capital Transfers:
The transfer of title to fixed assets & the transfer of funds
linked to the sale or acquisition of fixed assets, gifts and
inheritance taxes…

 Sale & Purchases Of Non-Produced, Non-Financial

Assets:
 The right to natural resources, and the sale & purchase of
intangible assets (patents, copyrights, trademarks, franchises
and leases).
The Financial Account

 Three components:
 DirectInvestments: investor exerts some explicit
degree of control over the assets
 Portfolio Investments: investor has no control over the
assets
 Other Investments: consists of various short-term and
long-term trade credits, cross-border loans, currency
deposits, bank deposits and other A/R and A/P related
to cross-border trade
Direct Investment
 This is the net balance of capital dispersed from and into
the country for the purpose of exerting control over
assets.
 When the capital flows out of the U.S., it enters the BOP as a
negative cash flow and vice versa

 Foreign direct investment arises from 10% ownership of

voting shares in a domestic firm by foreign investors.
 Concern for FDI: control and profit.
 E.g: Restrictions on what foreigners may own in their country.
 Portfolio Investment

 This is the net balance of capital that flows in and out

of the country but does not reach the 10% threshold of
direct investment.
 E.g: The purchase/sale of debt securities across borders

 Profit-motivated (return), rather than to control or

manage the investment.
→ much more volatile than net foreign direct investment
over the past decade
The United States Financial Accounts and Components,
2002-2010 (billions of U.S. dollars)
The United States Financial Account, 1985-2016 (billions of
U.S. dollars)
Current and Combined Financial/Capital Account Balances for the
United States, 1992-2010 (billions of U.S. dollars)
Official Reserves Accounts

 The Official Reserves Account is the total reserves held by

official monetary authorities within the country.
 These reserves are normally composed of the major
currencies used in international trade and financial
transactions (hard currencies).
 The significance of official reserves depends generally on
whether the country is operating under a fixed exchange
rate regime or a floating exchange rate system.
Net Errors & Omissions

 The BOP must balance unless something has not been counted or has been
counted improperly
 A subaccount of the BOP, may be imbalanced, but the entire BOP of a single
country is always balanced.
 The Net Errors and Omissions account ensures that the BOP actually balances.
U.S. Balance of payments accounts
Breaking the Rules: China’s Twin
Surpluses
 Exhibit 4.7 illustrates China’s highly unusual twin surplus in both the current
and financial accounts (these relationships are typically inverse)
 The rapid rise of the Chinese economy has been accompanied by a 10 fold
increase in foreign exchange reserves (Exhibit 4.8)
 As a result, China’s foreign exchange reserves are approximately 2.5 times
larger than the next largest (Exhibit 4.9)
China’s Twin Surplus, 1998-2016 (billions of U.S.
dollars)
China’s Foreign Exchange Reserves (billions of
U.S. dollars)
Largest Foreign Exchange Reserves (billions of U.S.
dollars)
Generic Balance of Payments
The BOP in total
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:
X = exports of goods and services Current Account Balance
M = imports of goods and services
CI = capital inflows
Capital Account Balance
CO = capital outflows
FI = financial inflows
Financial Account Balance
FO = financial outflows
FXB = official monetary reserves
The BOP Interaction with Key Macroeconomic
Variables

 A nation’s balance of payments interacts with nearly all of its key

macroeconomic variables
 Interacts means that the BOP affects and is affected by such key
macroeconomic factors as:
 Gross Domestic Product (GDP)
 The exchange rate
 Interest rates
 Inflation rates
 The BOP and GDP

 In a static (accounting) sense, a nation’s GDP can be

represented by the following equation:
GDP = C + I + G + X – M

C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the current account balance
The BOP and Exchange Rates

 A country’s BOP can have a significant impact on the level of its exchange
rate and vice versa
 The relationship between the BOP and exchange rates can be illustrated by:
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
 The BOP and Exchange Rates

 Fixed Exchange Rate Countries

 Under a fixed exchange rate system, the government bears the
responsibility to ensure that the BOP is near zero

 Floating Exchange Rate Countries

 Under a floating exchange rate system, the government has no
responsibility to peg its foreign exchange rate

 Managed Floats
 Countries operating with a managed float often find it necessary
to take action to maintain their desired exchange rate values
Trade Balances and Exchange Rates

 A country’s import and export of goods and services is

affected by changes in exchange rates
 The transmission mechanism is in principle quite simple:
changes in exchange rates change relative prices of
imports and exports, and changing prices in turn result
in changes in quantities demanded through the price
elasticity of demand
The BOP and Interest Rates
 Interest rates are used to intervene in the foreign
exchange market,
 The overall level of a country’s interest rates
compared to other countries does have an impact on
the financial account of the BOP
 Relatively low real interest rates should normally stimulate an outflow
of capital seeking higher rates elsewhere

 In the case of the U.S., the opposite has occurred due to perceived
growth opportunities and political stability – allowing it to finance its
large fiscal deficit

 It is beginning to appear that the favorable inflow on the financial

account is diminishing while the current account balance is worsening
– making the U.S. a bigger debtor nation vis-à-vis the rest of the world
BOP and inflation rates

 Imports have the potential to lower a country’s inflation

rate.
 On the other hand, to the extent that lower-priced
imports substitute for domestic production and
employment, gross domestic product will be lower as the
balance on the current account falls with rising imports.
Capital Mobility

 The degree to which capital moves freely across borders is

critically important to a country’s balance of payments
 The free flow of capital in and out of an economy can
potentially destabilize economic activity or can contribute
significantly to an economy’s development
 Agreement was careful to promote free movement of
capital for current account transactions (e.g., foreign
exchange or deposits) but less so for capital account
transactions (e.g., foreign direct investment)
Capital Controls

 A capital control is any restriction that limits or alters

the rate or direction of capital movement into or out of
a country
 Free movement of capital is more the exception than
the rule
Capital Flight

 Capital flight occurs when capital transfers by residents

conflict with political objectives.
 Many heavily indebted countries have suffered capital
flight, compounding their debt service problems.
 Capital can be moved via international transfers, with
physical currency, collectables or precious metals, money
laundering or false invoicing of international trade
transactions.
Summary